Jack Snyder
We're here at the Pershing Insights Conference outside of our nation's capital. We've had many conversations over the last few days with financial advisors, and the topic that keeps coming up is the topic of PIK interest. Our Senior Portfolio Manager and Head of Portfolio Management, Steve Rubinstein: can you give us a little bit of color on exactly what PIK Interest is and ultimately how you evaluate that when you're thinking about adding credits to our portfolios? Steve, take it away.
Steve Rubinstein
Hi Jack, thanks for having me on. Sounds like the conference is going well. We get this question all the time, so let's start from the top. PIK (“P – I – K”) stands for payment in-kind interest. What does that mean? Instead of paying 100% of the interest due in cash, a portion of the interest payment that is paid “in-kind” is capitalized to the loan and ultimately paid at maturity. So, let's just do a quick example. If a borrower has $100 million loan at a 10% all in interest rate, they would owe the lender $10 million, typically in cash. If that loan has the option to borrow 2% in PIK, the interest that the lender would receive would be $8 million in cash, and then 2% would be capitalized to the principal balance. At the end of the year, the principal balance moves from $100 to $102. Historically, this PIK option was really never offered at origination for new performing private credit loans. However, over the last couple of years, we've seen it more available given rising interest rates.
The way Antares thinks about it is we limit it to really what we think are the top quartile opportunities. The most common structure in the market today is for the base rate, or SOFR, will be paid in cash. The borrower then has the option to PIK half of the spread for the first two years of the loan. It's not a free option, however, there is a cost premium associated with this flexibility and, interestingly enough, most borrowers choose not to use it. If a manager is offering this, like I said, top quartile 20 plus percent of the portfolio, it's not necessarily a cause for concern. In a performing portfolio that's primarily comprised of first lien debt, you really should expect to see very little PIK. This built-in PIK option was actually historically more common in junior capital structures like mezzanine or second lien tranches. PIK interest is also a tool that is occasionally used by a manager during a workout to provide short term liquidity for what is likely an underperforming borrower. Importantly, this too is not a free option, and a manager will only offer this when the sponsor provides incremental equity at least equal to what the lenders are offering as PIK.
Investors really should spend a fair amount of time looking at the dispersion in PIK interest across the BDCs. High PIK interest as a percent of total income could be a signal of a higher amount of junior capital or subordinated investments within the BDC portfolio. But really potentially more concerning is that increasing PIK may be a potential early warning sign of underlying credit deterioration. At Antares, we are intentional about our limited use of PIK interest and believe our funds, including our BDCs, compare very favorably on this metric.
Thanks for having me on Jack and really look forward to discussing the next hot topic. Take care and good luck at the rest of the conference.
Jack Snyder
Steve, thank you for those insights. A lot of exciting things happening in the private credit markets. Watch for insights on future videos. Thank you.